Why is the uptake of equity finance so weak?

The Goverment must address the lack of interest in equity finance. But forget
tax incentives, entrepreneurs just need to know they will get a fair deal

Expert view: 'the prospect of trying to negotiate a decent deal with financial experts puts plenty of business owners off'

By James Hurley

12:00PM GMT 12 Feb 2014

At a gathering of tech start-ups in east London earlier this month, one of the fledgling entrepreneurs in the audience complained bitterly to a panel of entrepreneurs and investors that his business plan had been given short shrift by a number of high street banks.

One of the incredulous panellists, an experienced angel investor, delivered some home truths: “I’d be worried if a bank was lending to you even in the good times.”

His intention was not to issue a damning verdict on the quality of the start-up itself – he was simply highlighting that bank debt is typically an entirely inappropriate source of seed financing for a high-risk tech start-up.

Sadly, that kind of common sense about the funding landscape is not that common in the UK.

A study by the CBI revealed that, while half of all UK small and medium-sized enterprises use bank debt, a paltry 3 per cent use equity finance, compared with a European average of 7 per cent. The assumption among SMEs is generally that the bank is the only game in town.

However, the business group found that two-thirds of companies that had used equity finance said it had had a positive impact, with four out of five saying they would use it again and recommend it to other entrepreneurs. So why is uptake so weak?

As well as ignorance of where to find equity finance, and even of how it works, among small companies, there is also widespread fear among entrepreneurs – some of it justified – about losing control and even ownership of their own businesses if they sell a stake in them.

Long before bankers were being publicly castigated, the media was portraying private equity as “locusts”, and similarly unflattering views of both venture capitalists and angel investors still persist among small companies.

Stories of sharp practices, including putting hidden terms in deals, taking unreasonable stakes and forcing founders out do not help. Business owners also tend to assume anything other than the bank will involve a painful, expensive and time-consuming application process.

That can be true but, equally, plenty of myths about equity finance persist. For instance, growing companies do not always need to sell a majority stake to secure equity funding, so staying in control is possible.

It might even be safer to have a minority equity partner on board than a secured loan on the books; those who find themselves unable to pay back secured bank debt really do stand to lose everything.

The prospect of trying to negotiate a decent deal with financial experts probably puts plenty of business owners off. A senior venture capitalist has told me of his shock at the ignorance of some rudimentary financial concepts among often extremely successful entrepreneurs once they get around the table.

It might suit the shadier end of the venture and angel markets if this imbalance of power remains, but it is at the expense of a better funding environment for businesses.

Those hoping that a return to confidence among banks will render this debate moot are mistaken. Despite signs of recovery, as our wise angel investor panellist told the fledgling entrepreneur at the tech networking shindig, there is no prospect of banks going back to lending to projects that are at best only appropriate for proper risk capital – which means equity.

The CBI wants to see more Government measures to boost equity finance but throwing more tax incentives at the problem is unlikely to help until equity investors are doing a better job of communicating with small companies – and when entrepreneurs are confident of getting a fair deal as a result.

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